Bonds Run Into GDP Bump in the Road

While the stock market was awash in green, Treasuries limped along in the wake of this morning's better-than-expected Gross Domestic Product report. Today's GDP data deflated worries about a recession and reduced hopes for several more interest-rate reductions by the Federal Reserve .

To be certain, the bond market isn't abandoning all hope rates will be cut again. It just doesn't reflect the belief Alan Greenspan and gang will be all that aggressive.

Indeed, the latest pricing of the fed funds futures -- a good proxy of where the bond market expects interest rates to move -- indicates the market expects the Fed to ease short-term interest rates by 25 basis points to 4.25% when it next meets on May 15. The July fed funds futures contract also prices a 100% chance of the Fed further cutting rates by another 25 basis points to 4% by the beginning of the summer. The Fed meets for two days beginning July 26. But it all stops there. The fed fund futures indicate the market does not currently expect rate cuts after July.

According to Tony Crescenzi, chief bond market strategist at Miller Tabak, today's GDP report is important from a "psychological standpoint." The better-than-expected news about the economy makes it more difficult for analysts and investors, many of whom remain in the recession camp, to justify aggressive easing by the Fed. "If there's recession, it will have to take place in the second half of the year, but that's when most expect a rebounding to unfold due to rate cuts and inventory correction," Crescenzi reasoned. It takes about six to nine months for rate cuts to work their way through the economy. The Fed began a series of rate cuts on Jan. 3.

Yet there is no doubt today's figures still reflect weakness in the economy. GDP grew 2% in the first quarter, growing more than it did in the fourth quarter, thanks to increases in consumer spending on durable goods, an upturn in housing and an unexpected narrowing in the trade deficit. But the economy still was hampered by another sharp decline in business investment, which clearly indicates that capital spending - one of the Fed's largest concerns -- remains weak. And the economy is growing at a much weaker pace than it did in recent years.

The bond market therefore sees that more rate cuts could be appropriate, Crescenzi said.

Lately, the two-year Treasury note, which reacts most dramatically to changes in monetary policy, was off 4/32 to 99 18/32, with the yield was up to 4.222%. Yields move inversely to prices.

The 10-year benchmark Treasury note fell 19/32 to 97 31/32, raising the yield to 5.265%. The 30-year Treasury bond, also known as the long bond, tumbled 21/32 to 95 18/32, yielding 5.757%.

Michael Maurer, a debt strategist at A.G. Edwards & Sons, pointed out that today's better-than-expected GDP report had a "sizable effect" on the short end of the market, which was expecting a weaker GDP figure. The long end of the market already had priced in an economic recovery.

And what bodes for the coming week? "I think the market is also keeping a wary eye on the NAPM report next week and also employment numbers at the end of the week," Maurer said, referring to thepurchasing managers index from the National Association of Purchasing Management as well as the next jobs report that will be released by the Labor Department next Friday. The NAPM report is an important gauge of the health of the manufacturing sector.